In my last post I discussed dividends which are one method which company management can use to return value to shareholders. The other main method is what is known as stock buybacks. The official term is share repurchases, but I’ll use buybacks as that is the term most commonly used.

I’ll first define stock buybacks, and then provide a quick example of how they work.

What are stock buybacks?

Stock buybacks occur when a company uses cash to purchase it’s own stock from current shareholders. This results in a few immediate effects. Reduction in the number of shares outstanding, reduction in the cash held by the company, change in the value of the company, and most of the time a change in the per share value of the company.

Example

Prior to a stock buyback, a company has the following characteristics:

$1,000,000 in cash, $9,000,000 in other assets and no debt. This means the company has a value of $10,000,000.

100,000 shares outstanding, valued at $100/share

You own 1,000 shares of the company.

The company decides to use all $1,000,000 of its cash to buy back shares of it’s stock at $100/share. Assuming they are able to find sellers for the full 10,000 shares, the company will reduce it’s outstanding shares by 10,000. This will also reduce the cash held by the company and reduce the value of the company.

After the stock buyback, the company has the following characteristics:

$0 in cash, $9,000,000 in other assets and no debt. This means the company has a value of $9,000,000.

90,000 shares outstanding, valued at $100/share.

You own 1,000 shares of the company.

In this example, someone who didn’t sell their shares to the company doesn’t seem to have gained much from this action. Their shares are still worth $100/share and they haven’t received any cash or additional shares. However, they have increased their ownership in the company.

What is the effect on you?

Both before and after, the value of your holdings is $100,000.

Before the buyback, you owned 1.00% of the company.

After the buyback, you owned 1.11% of the company.

The buyback increased your ownership in the company by 11%. Although the buyback didn’t provide you with an immediate gain in portfolio value, it did change your ownership % in the company. This increase will mean that any future earnings from the company are due to you at a larger percentage than they were before.

The fact that your portfolio value didn’t change directly due to the buyback is exactly the same way that dividends work. Assuming both dividends and buybacks are taxed in the same way, there should be no preference between the two.¹ Both are methods that return cash to shareholders. The difference is that dividends are paid to all shareholders without any requirement of selling their shares, while share buybacks use cash to pay fewer shareholders that have to sell their shares to get the cash.

In this example, the per share value of the company didn’t change with the buy back. The reason is that the market price and the book value were the same. If the market price was different than the book value, then the per share value of the company would change as well. If the market price of the company is above the book value, then the per share value of the company will go down. However, if the market price of the company is below book value, then the per share value of the company will increase.This is a very important point to remember. Most company managers don’t realize this and end up destroying shareholder value by performing buybacks at the wrong time. Be aware of this next time you see a company buyback announced.

Takeaways

Stock buybacks are just one way of returning value to shareholders. The other most common method is dividend payments. When a company repurchases their own shares, the number of shares outstanding decreases. The percentage ownership for continuing shareholders will increase, but the overall value of the company will go down by the amount of cash spent to repurchase the shares. Unlike with dividends, it is important to consider the market price vs the book value when choosing to perform a stock buyback.

What do you think of stock buybacks? Would you want companies that you own to perform them? Leave your thoughts in the comments below.

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¹Taxes will drastically affect the relative performance of dividends and share buybacks. In the United States, dividends are taxed while share buybacks are not. That is why, at the time of this writing, many companies are relying more and more on share buybacks to return cash to shareholders instead of dividends.

In this article, I introduce the concept of dividends. Dividends are often stated as a major source of investment return.

In this post I’ll address:

How dividends are commonly portrayed

Define dividends

Show an example of the reality of dividends

Address how dividends can be deceiving

How dividends are often portrayed (“Free Money”)

Dividends are often portrayed as some sort of “free money” or other type of miraculous key to successful investing. There are many strategies on the internet about the benefits of “dividing paying stocks” or “dividend growth investing.” All of these strategies follow a common theme.

When you buy stock in a company that pays dividends, you can receive a regular income source from the company. That company will pay you every quarter for holding their stock, which you can reinvest and use to buy more stock or take as cash to spend. This idea boasts two benefits. First, when you are in the wealth accumulation phase (working, saving for the future/retirement, etc…) your dividends can be used to buy a greater ownership share in the company. Second, when you are in the wealth draw-down phase (retired, spending your savings and investments) your dividends can be a replacement for your working income. This is where the phrase “live off your dividends” comes from.

Both of these concepts are true, but they are also deceptive. I’ll address why they are deceptive later in the post. Before we can address that, we need to properly define dividends.

True definition of Dividends

A dividend is the portion of a company’s earnings which the company chooses to return to shareholders in the form of a cash payment.¹

This definition is important. There are two key points.

First, that dividends come from earnings. They do not appear out of nowhere, and because it is real cash paid to an investor, you can’t fake dividends. At least not for long. This is why consistent dividend payments or changes in the amount of dividends paid is often used as an indicator of the strength of quality of a company. The counter example is a company such as Enron, where they reported great financial results. However, these results weren’t backed up by anything. If Enron had been paying a regular dividend, their fraud would have been caught much earlier because they wouldn’t be able to lie about cash they pay to shareholders.

Second, that a company chooses to return this money to shareholders. Dividends are not guaranteed, they are voluntary. Each time you receive a dividend, company management made a conscious choice to pay that cash to you. This decision is made each and every quarter.² Just because a company is shown to be paying a dividend when you buy it, there is no guarantee that they will pay that same amount the next quarter. The company could easily choose to reduce the dividend payment, or stop paying dividends altogether.

The takeaway from this is that you have to be careful about making investment decisions solely or even with a focus upon dividend paying companies. On it’s own, the dividend payment history of a company will not tell you anything about the future performance of the company. A company that has been paying consistently increasing dividends for decades could stop those payments tomorrow, and a company that has never paid a dividend could begin doing so. This is one reason why it is important to focus on the fundamental strengths and weaknesses of the business and not on a company’s stock price or dividend history.

Example – The reality of dividends

When a company pays out a dividend the price of the company’s stock and the value of the underlying business change. Both of these issues are important.

Let’s use a hypothetical company priced at $100 per share which earns $10/share a year in profit. Our hypothetical company has assets of $150 per share of which $100 is cash and $50 are other assets such as buildings, land, and equipment. They also have $50 per share of debt in the form of loans to the bank. This means that shareholders equity, or book value, of the company is also $100 per share. ($150 assets – $50 debt).

In this example our hypothetical company has a book value of $100 per share and a price of $100 per share. This almost never happens in real life, as the market no longer uses book value as the basis for a value of a company anymore. Most companies are valued based upon how much money they will earn in the future, and not how much they have currently.

The $10/share of annual profit equates to $2.50/share each quarter. Company management decides that they would like to pay a $1.00 per share dividend this quarter. So what happens?

Based upon how dividends are portrayed as “free money” one would expect that the company pays out the dividend and neither the company’s price or value is effected. That isn’t true though.

When a dividend is paid, the cash paid to each shareholder is deducted from the cash held by the company. This reduces the book value of the company when it pays you a dividend. Therefore, the value of the company is reduced every time it pays a dividend. In addition, when a dividend is paid, the stock price of the company is automatically adjusted by the stock market by the amount of the dividend. Therefore, in our example, if the company pays a $1.00/share dividend, then the stock price would automatically adjust from $100/share to $99/share after the dividend is paid. The same would drop would occur in the book value of the company.

We are going to look at two points in time, before the dividend is paid and after the dividend is paid. Let us assume that you own 10 shares of company stock prior the dividend payment.

Before the dividend is paid:

You own 10 shares of stock, priced at a market value of $100/share. You have $0 in cash. The market value of your portfolio is $1,000.

You own 10 shares of stock, with a book value of $100/share. You have $0 in cash. The true value of your portfolio is $1,000.

After the dividend is paid:

You own 10 shares of stock, priced at a market value of $99/share. You have $10 in cash. The market value of your portfolio is $990 in stock + $10 in cash = $1,000.

You own 10 shares of stock, with a book value of $99/share. This is because the company only has $99 of cash per share after paying you $1 of their $100/share of cash. The true value of your portfolio is $990 in stock + $10 in cash = $1,000.

Dividends can be deceiving

The first deception that I mentioned above, was that dividends, when reinvested, allow you to purchase a greater share of ownership in a company over time. This can be true, but understates some problems. As I have just shown, when you receive a dividend you are not actually increasing the value of your portfolio in any way. You don’t magically have more money with which to buy a larger ownership share in the company. If you started with $1,000 of ownership in the company, you ended with $1,000 of value. If you don’t reinvest your dividends, then you end up $990 of ownership in the company, and $10 of cash. If you reinvest your dividends, then you end up with $1,000 of ownership in the company. The only change which has taken place is that now you own more shares which are each worth less individually. The overall value is the same.

Note, this can increase your ownership share without increasing the value of your portfolio. If you choose to reinvest your dividends then you will now own more shares. Assuming only some of the people who receive the dividend reinvest it, then you’ll now own a larger part of the company. However, if everyone were to always reinvest their dividends, then everyone would increase their number of shares at the same rate. You wouldn’t actually be increasing your ownership in the company. You’d simply be owning more shares of an ever larger number of shares. This isn’t a realistic situation, as it would imply that no one ever sold any shares of the company. It is an important distinction though.

The second deception is that you can simply live off of your dividends in retirement. This can be true, if you have a large portfolio of stocks that regularly pay dividends. However, as I have shown, there is nothing miraculous about dividends. If you were to spend the $10 of cash dividends, it would reduce your portfolio value to $990. This isn’t any different than selling $10 worth of stock from a $1000 portfolio and ending up with a $990 portfolio. The only benefit of spending only your dividends in retirement is that dividends can provide an easy tool for withdrawing a sustainable portion of one’s portfolio. This is based upon management only paying dividends which they can steadily pay over time and not decrease. Shareholders tend to get upset if management stops paying or reduces dividend payments. As mentioned above, dividends are voluntary so this doesn’t prevent it from happening. However, it does make the reduction of dividends less likely.

Conclusion

It is important to remember that dividends are simply the portion of a company’s earnings which management chooses to pay out to shareholders. This means that dividends are tied always to the performance of the company. Dividends are also voluntary, so they shouldn’t be solely depended on. Finally, the payment of dividends doesn’t actually increase the value of your portfolio. They can be beneficial, but they aren’t free money.

Is this a view on dividends you haven’t heard before? Please add your thoughts to the comments below.

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¹Dividends can be paid in the form of cash or stock. However, I am only considering cash dividends in this post as they are the predominant form of dividends.

²Most dividends are paid quarterly. Some companies make dividend payments only once a year, or make special dividend payments outside of a regular payment schedule. My example assumes quarterly dividend payments.

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